Fed's Focus And Rate Unchanged

By JEREMY W. PETERS; Vikas Bajaj contributed reporting from New York.

Published: August 8, 2007

The Federal Reserve kept its key interest rate unchanged on Tuesday and signaled that it still expected to avoid cutting short-term rates despite the recent tumult in credit markets and on Wall Street. The Fed suggested that it would change course only if economic conditions deteriorate badly in the weeks and months ahead.

In a statement announcing that the overnight lending rate it controls would remain unchanged at 5.25 percent, the Fed's policy-setting Federal Open Market Committee did not drift significantly from its core message that inflation remains a greater risk to the economy than recession.

The central bank, however, softened its tone slightly by giving some recognition to worsening conditions in financial markets, by adding a new phrase to its statement saying that the risk of an economic downturn has ''increased somewhat.''

''The Fed threw the markets a bone, commenting on recent market volatility and tighter credit conditions,'' Steven A. Wood of Insight Economics wrote in a commentary. ''However, they gave no hint that they would act anytime soon.''

On Wall Street, traders had difficulty sorting out the Fed's message and by the end of the day still seemed convinced that the Fed was keeping the door open to a rate cut later this year. After falling sharply minutes after the statement was released around 2:15 p.m., stocks later rebounded, finishing trading modestly higher. The Standard & Poor's 500 stock index gained 0.6 percent and the Dow Jones industrial average added almost 36 points to close at 13,504.30.

In the futures market, the odds of a rate cut by the end of this year were reduced somewhat but still remained greater than even. Many on Wall Street had hoped that the recent tightening in credit markets would prompt the Fed to more clearly signal a shift in its focus from concern about inflation toward a greater fear of an economic downturn.

But the Fed gave Wall Street something much less definitive.

''I think this means that the Fed isn't preparing the market for a rate cut anytime soon,'' said Tom Gallagher, a Fed analyst with the ISI Group in Washington, a financial research firm. ''On the other hand, they set up a statement that they could use to justify a rate cut if things deteriorate faster than they now expect.''

The Fed statement noted that ''financial markets have been volatile in recent weeks, credit conditions have become tighter for some households and businesses, and the housing correction is ongoing.''

''Nevertheless,'' the statement continued, ''the economy seems likely to continue to expand at a moderate pace over coming quarters, supported by solid growth in employment and incomes and a robust global economy.''

Analysts said that the Fed appeared to be saying that the recent volatility in the markets did not appear to be spreading much beyond Wall Street.

''They acknowledged that there is uncertainty in the markets, but that uncertainty remains a financial issue rather than a real economic issue,'' said Jack Caffrey, an equity strategist with JPMorgan Private Bank. ''And ultimately, they're going to take their direction from the real economy.''

The stock market has been on edge in recent weeks as concern spread that tighter lending standards for everyone from large corporations to prospective home buyers could cause the economy to seize up. But the Fed saw that as unlikely to happen.

Ben S. Bernanke, the Fed chairman, told Congress three weeks ago that the central bank's economic forecast for the year had become only slightly more pessimistic since February, despite the growing problems with housing.

Analysts said one reason for the Fed's stance is that under Mr. Bernanke the central bank is more reluctant to bail out those suffering from financial losses than it was under his predecessor, Alan Greenspan, who was much more willing to ease credit in times of market uncertainty.

''Ben Bernanke is more standoffish,'' said Drew Matus, an economist with Lehman Brothers. ''He's the guy sitting there watching the kids in the playground. And if there's a fight, he's going to stay out of it unless somebody's going to get hurt. Greenspan was more like a doting parent.''

But the recent tightening in the credit markets poses the most significant challenge to policy makers since the Fed stopped raising rates in June 2006. In the last year, the central bank has been able to hold rates steady as economic growth moderated and it appeared that underlying inflation would soon slow to a pace of under 2 percent a year.

Now, however, policy makers appear to be facing a more jarring -- and complicated -- reality. The economy and the job market remain relatively healthy and the Fed's preferred inflation gauge -- the price index for personal consumption spending excluding food and energy -- has come down to a 1.9 percent rate after running as high as 2.5 percent early this year. But the credit market tightening has significantly raised longer-term borrowing costs for consumers and businesses.

In addition to the challenge of conducting monetary policy, there is new evidence that the productivity advances of the past decade may be ebbing.

Productivity grew at a 1.8 percent rate in the second quarter, the Labor Department said on Tuesday, but the gains of previous years were revised downward. For the first quarter, worker productivity grew at a 0.7 percent rate, off from the earlier estimate of 1 percent, and the advance for all of 2006 was set at just 1 percent, the slowest since the surge in productivity began in the mid-1990s.

Analysts on Wall Street found themselves in the awkward position of looking forward to more trouble in the economy before the Fed might come to the rescue.

If economic conditions get much worse and the Fed is ''more comfortable with the inflation outlook, that's a catalyst for an eventual easing in monetary policy,'' said Richard Berner, chief United States economist with Morgan Stanley. ''But we're not there yet.''

Chart: ''The Fed's Words'' In its policy statement released today, the Federal Reserve made only slight changes to a paragraph that had been unchanged since March. (Source: Federal Reserve)(pg. C7)